A pet peeve of mine is how most accountants go about offering tax planning services. Although I made mistakes when I first started my practice, I changed the way I approach this topic about 10 years ago, largely for one big reason: Any tax move you make today will affect the client 20 to 30 years down the road.
In light of this, I started making decisions with this principle in mind. For example, after the TCJA, I converted approximately 80 percent of my S-corporation clients to C-corporations. I did this because these clients either didn’t qualify for the IRC §199A deduction, due to the fact that their AGI was either too high, or they were a professional who was excluded from the 20 percent deduction on their QBI.
When it comes to tax planning, I look at each client differently. Furthermore, if I converted them from an S- to a C-corp, I spoke with them and asked what they were spending their distributions on. Interestingly enough, because a 2 percent shareholder or owner of an S-corporation or partnership is precluded from employee benefits, the majority of my clients said they were spending money on healthcare, Health Savings Accounts (HSAs), vehicles, gym memberships, etc. In addition, most had either Solo 401(k) or Safe Harbor 401(k) Plans to reduce their personal income.
When I went into practice, I was told and believed that making 401k contributions at the employee level accomplished getting a tax deduction in your “income earning” years, when your tax bracket was higher. Then, when you disbursed your retirement fund, the theory was that your income tax bracket would be lower.
However, a few years ago, I read an article. I tend not to do this often because they are typically nothing more than someone’s opinion. However, this one caught my attention, especially because it touched on converting to a C-corporation. Roth IRAs receive post-tax contributions and are subject to AGI limitations. However, these contributions grow tax free, and if they are left in the account for a period of five years, they are tax free when they are pulled out. That doesn’t mean that there is no penalty for early withdrawal, but there is no income tax.
In 2019, the maximum Roth IRA contribution is $6,000 for those under 50 and $7,000 for those 50 and older. However, if you are single, these contributions begin to phase out with a MAGI of $122,000, and if you are married, the phase-out begins at a MAGI of $193,000.
In fact, most 401(k) plans have a Roth option embedded in them. The contribution limit for employee deferrals is $19,000, and for those 50 or older, the limits is $25,000. When other income is removed from the individual tax level, the majority of clients are not in a tax situation. Therefore, the 401(k) deferral to the Roth portion will not increase their individual tax situation to an extremely high level.
Back to the article I read. It stated that when taxpayers retire, they spend 70 to 80 percent of their income on healthcare. They take taxable distributions from their retirement accounts to pay these expenses. This results in higher taxable income and few options for deducting those expenses. However, if these same people used a Roth for this purpose, there would be no taxable effect.
In sum: When it comes to tax planning, don’t believe everything you read or everything you were taught in the early years of your practice. Treat each client as an individual and check and see if the retirement account they are contributing money to really fits their plans 20 to 30 years in the future.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...